Question

What is capital structure and how important it is? How is the cost of capital related to capital structure?

Answer 1

The capital structure of a firm is based on the arrangement of different sources of funds which are used to finance the operations of the firm. It is generally consists of debt, preferred stock and common equity. It is important because an optimum mix of capital structure is good for overall business of the firm.

The effective cost of capital for a company is the weighted average cost of capital (WACC). It is the cost of raising capital, where the weights represent the proportion of each source of financing that is used in capital structure of the company. It is used as a discount rate in net present value calculation. The present value of expected return is calculated by discounting the expected cash inflows at effective cost of capital of the company. It is an important factor to make capital budgeting decisions and analyze the worth of a new project.

The weighted average cost of capital (WACC) is the cost of raising capital, with the weights representing the proportion of each source of financing that is used in capital structure and WACC can be calculated with the help of following formula

WACC = [E/ (E+D+P)]* re + [D/ (E+D+P)] * (1-t) * rd + [P/ (E+D+P)] * rp

Where, re is the cost of equity

And rd is the cost of debt

t is tax rate of company

And rp is the cost of preferred stock

E is the value of common equity

P is the value of preferred stock

D is the value of debt